A Sea Change - For Venture Capital

"Sell off the big stocks, the small stocks, the value stocks, the growth stocks, the U.S. stocks, and the foreign stocks. Sell the private equity along with the public equity, the real estate, the hedge funds, and the venture capital. Sell it all and put the proceeds into high yield bonds at 9%." This provocative statement was made by Howard Marks, Founder of Oaktree Capital, during a December meeting of a non-profit investment committee.

If you haven't ever read Howard Marks’ letters, they stand out as invaluable resources for investors, offering a historical perspective on investing. While the above advice is provocative and shouldn't be taken as literal investment counsel, it underscores what might be a significant shift in institutional investor allocation.

In his latest letter, "Further Thoughts on Sea Change", Marks delves into why he believes we're entering a new era post-ZIRP (Zero Interest Rate Policy) regarding asset allocation among institutional investors. I won't reiterate all of his insights, but his core argument suggests that the low-interest environment from 2009 - 2021 was a deviation. With no imminent return to near-zero or drastically plummeting interest rates, he anticipates “tougher times for corporate profits, for asset appreciation, for borrowing, and for avoiding default." Essentially, the investment landscape has fundamentally shifted, and relying solely on strategies successful since 2009 may prove unwise.

For VCs, this potentially signifies subdued growth rates for many companies and diminished exit multiples in comparison to the ZIRP period. There are two main takeaways from this. The strategies that prospered for VCs in the ZIRP era might falter now – a topic I delve deeper into in another post titled “Hitting Home Runs in a Post Steroid Era”.

The secondary concern involves asset allocation by Limited Partners (LPs). It's crucial to remember that VCs aren't solely vying for peers for investments from institutional investors. There's also competition from all the other market alternatives. For a prolonged phase, public tech stocks (and by extension VC) were virtually the only avenue to generate solid returns, given the abysmal yields elsewhere. But this dynamic seems to have shifted, and there's little evidence suggesting a reversal.

So what implications might this hold for VC investors and founders? The available capital might diminish in the foreseeable future. When assessing Private Equity (where I categorize VC), some inherent challenges arise: its illiquid nature, extended holding durations, and high volatility. The primary allure for institutional investors has been the prospect of superior returns. But with high yield bonds now offering 9%, the appeal can diminish.

Given no foreseen dramatic drop in interest rates, this scenario could also depress the valuation of public tech stocks, exerting further strain on the PE and VC arenas. Coupled with the enormous funds amassed by VC and PE entities, I suspect private market pricing won’t compress in lockstep with public prices, potentially further narrowing returns.

Don’t take this as doom and gloom for VC and venture-backed companies. We will continue to see great companies created, and there will be many fund managers that will outperform bonds, credit and the S&P. Think of this more of a sorting out that will take place over the next 2 - 5 years.

I continue to be a big believer in the VC asset class and the importance this has on funding the most significant companies in our economy. This paragraph from Adams Street sums up the importance of venture capital in the current economy. “According to the National Venture Capital Association, VC-backed companies make up about 77% of US public market capitalization, 81% of total patents granted by the US Patent and Trademark Office, and 92% of research and development (R&D) spend. Since 2001, 53% of all initial public offerings (IPO), and 70% of tech companies going public had VC backing, according to Professor Jay Ritter at the University of Florida. Still, venture accounts for less than 1% of total capital market assets.”

But I still suspect institutional investors will pull back from VC a bit, and this environment will favor fund managers with a clear, consistent strategy, a long track record of returns and an experienced team that has managed funds through choppy times. I also suspect this will favor smaller funds, especially early-stage funds where there is still a lot of upside even if entry prices remain high. The large multi-stage capital aggregators likely will also stay the same size or even grow for different reasons.

For founders and VCs, I think it will become increasingly important to not overfund and overvalue companies going forward. We’re starting to see companies that are performing well (e.g. Loom) exit below the valuation of their last round. Unreasonably high valuations and large amounts of growth capital in those companies are compressing returns for everyone, including the early-stage investors. This isn’t good for founders or investors. There will be a lot of solid companies that struggle under the weight of and expectations set by high valuations and too much capital. This will need to be corrected going forward. For founders, choosing your investors and partners will be ever more important.

While this Sea Change is creating a more challenging environment, I also think there is a lot of positive that will come out of this. When money isn’t freely available, incentives between founders and investors are better aligned. Excess capital and inflated valuations push companies to grow at all costs, which create companies reliant on cheap capital to continue to grow. In the long run, this isn’t good for founders, employees or investors.

While a sea change might make it harder for companies to grow, great founders will persist and great companies will emerge. There will continue to be exciting new advancements in technology and innovation. AI, for instance, will have a dramatic and potentially deflationary impact on the economy. This HBS & BCG study shows just how impactful this will be in our everyday lives, even for highly educated knowledge workers. Technology and innovation will continue to march forward, but how we build and fund companies will likely change or revert back to the pre-ZIRP era. We are definitely in one of those periods where the tide is receding, and I suspect many of the tourists will pull back.